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1 econstor Der Open-Access-Publikationsserver der ZBW Leibniz-Informationszentrum Wirtschaft The Open Access Publication Server of the ZBW Leibniz Information Centre for Economics Papadimitriou, Dimitri B.; Phillips, Ronnie J.; Wray, L. Randall Research Report An alternative in small business finance: Communitybased factoring companies and small business lending Public policy brief // Jerome Levy Economics Institute of Bard College, No. 12 Provided in Cooperation with: Levy Economics Institute of Bard College Suggested Citation: Papadimitriou, Dimitri B.; Phillips, Ronnie J.; Wray, L. Randall (1994) : An alternative in small business finance: Community-based factoring companies and small business lending, Public policy brief // Jerome Levy Economics Institute of Bard College, No. 12 This Version is available at: Nutzungsbedingungen: Die ZBW räumt Ihnen als Nutzerin/Nutzer das unentgeltliche, räumlich unbeschränkte und zeitlich auf die Dauer des Schutzrechts beschränkte einfache Recht ein, das ausgewählte Werk im Rahmen der unter nachzulesenden vollständigen Nutzungsbedingungen zu vervielfältigen, mit denen die Nutzerin/der Nutzer sich durch die erste Nutzung einverstanden erklärt. Terms of use: The ZBW grants you, the user, the non-exclusive right to use the selected work free of charge, territorially unrestricted and within the time limit of the term of the property rights according to the terms specified at By the first use of the selected work the user agrees and declares to comply with these terms of use. zbw Leibniz-Informationszentrum Wirtschaft Leibniz Information Centre for Economics

2 The Jerome Levy Economics Institute of Bard College Public Policy Brief An Alternative in Small Business Finance Community-Based Factoring Companies and Small Business Lending Dimitri B. Papadimitriou Ronnie J. Phillips L. Randall Wray No. 12/1994

3 The Jerome Levy Economics Institute of Bard College, founded in 1986, is an autonomous, independently endowed re s e a rc h o rganization. It is nonpartisan, open to the examination of diverse points of view, and dedicated to public serv i c e. The Institute believes in the potential for the study of economics to improve the human condition. Its purpose is to generate viable, effective public policy responses to i m p o rtant economic problems. It is conc e rned with issues that profoundly aff e c t the quality of life in the United States and a b ro a d. The present re s e a rch agenda includes such issues as financial instability, povert y, unemployment, and problems associated with the distribution of income and wealth. Other re s e a rch interests include the issues of public and private investment and their relationship to prod u c t i v i t y, competitiveness, and the prospects for growth and employment. In all its endeavors, the Institute places heavy emphasis on the values of personal freedom and justice. Editor: Sanjay Mongia Associate Editor: Frances Spring A publication of The Jerome Levy Economics Institute of Bard College, Post Office Box 5000, Annandale-on-Hudson, NY Public Policy Brief is produced by the Bard College Publications Office: Ginger Shore, Director; Elena Erber, Art Director; Juliet Bell, Designer. Copyright 1994 by The Jerome Levy Economics Institute. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information-retrieval system, without permission in writing from the publisher. The Jerome Levy Economics Institute is publishing this Public Policy Brief, without necessarily endorsing its proposals, to make a constructive contribution and advance the debate on this issue. ISSN

4 Summary At a time when small businesses are suffering from a credit crunch, niche financial institutions increasingly are filling the void left by more traditional sources of financing, such as commercial banks. The authors of this re s e a rch Dimitri B. Papadimitriou, Ronnie J. Phillips, and L. Randall Wray argue that among the most important of these niche players are community-based factor companies, which are rapidly expanding beyond their traditional customer base in the a p p a rel and textile industry to finance a broad range of firms in everything from electronics to health care. Factors, which trace their roots back to the days of Hammurabi, four thousand years ago, when they made advances to manufacturers and m e rchants against goods, typically in the United States have been small, independent, and highly specialized firms focusing on providing credit and collection services to a select group of small businesses. However, during the last two decades the factoring industry has experienced widespread consolidation, diversification, and growth. Even as its traditional base of apparel and textile customers has lost ground to foreign competition, factoring volume, since the 1980s, has grown 8.6 percent annually to $50 billion in Growth has come from expanding into new markets such as health care, electronics, and foreign trade. At the same time the number of firms has shrunk as small factors have merged and in many cases been taken over by banks, which now control 94 percent of factoring in the United States. For example, the number of factors in New York City, the center of the apparel and textile trade, has plunged from 114 in 1935 to only 20 today. For small businesses there are many advantages to doing business with a factor. The purchase of accounts receivables by factors enhances the balance sheets of their clients because it improves their debt-to-equity and debt-to-asset ratios. Thus, factors can make it easier for small businesses to obtain bank financing. Factors also are willing to take an equity interest in their clients. In addition, full-service factors provide a range of services from bookkeeping and billing to inventory controls and data processing that banks do not off e r,

5 and availing themselves of these services allows small companies to focus on their core businesses. Because small-scale factors are more people intensive and more involved with the day-to-day operations of their clients than banks, they are particularly well suited to monitor the financial condition of their clients and to take on new clients that banks might consider too risky. The credit department of a factor, for example, is in a good position to judge whether work-outs will be cheaper than calling in loans and forcing bankruptcies. And because factors are more interested in the creditworthiness of a client s customers than of the client itself, they often extend loans in excess of collateral to rapidly growing small businesses. Thus, in an extreme case, a factor might take on a start-up business with no equity, no assets, and no credit record; if the factor believes the start-up s customers are creditworthy and the s t a rt-up can deliver the goods or services ord e red by its customers, then the factor will be willing to make advances to the start-up client once goods are delivered. The growth of factoring is particularly important now because small businesses an important engine of economic growth appear to have less and less access to bank capital. One major reason for this diminished access to funds is that the ranks of the smallest banks (those with less than $25 million in assets), which traditionally have provided the most financing for small firms, are dwindling; the total volume of loans made by these smallest banks fell 37 perc e n t between 1988 and At the same time the volume of loans by the largest banks (those with over $5 billion in assets), which typically do not lend to small firms, has grown 25 percent. Because factors are becoming an increasingly important source of financing for small and start-up businesses, the authors of this Levy Institute Public Policy Brief propose that factors be encouraged to play a broader role in financing firms in distressed communities. In some cases community-based factors should be eligible for funding and assistance under the administration s new community development financial institutions legislation. In addition, investment by banks in these factors should count toward compliance with the proposed new regulations for the Community Reinvestment Act.

6 C o n t e n t s Preface...7 Dimitri B. Papadimitriou Community-Based Factoring Compaines and Small Business Lending...9 Dimitri B. Papadimitriou Ronnie J. Phillips L. Randall Wr a y About the Authors

7 Preface Among the important developments in the changing financial system is the increasing role of factoring companies as a source of financing for many new ventures and small firms. There is a growing b ody of empirical literature, as well as a wealth of anecdotal evidence, to support the claim of a credit crunch constraining small and midsize businesses. Although skeptics refute this notion by attributing the relatively low level of c o m m e rcial bank lending to weak demand and slow economic growth, we have observed that in fact demand does exist and that demand has incre a s i n g l y been met by niche factors, which substitute for commercial banks in specific sectors. Factors, which in this country typically operated in the apparel and textile indust ry, have recently experienced tre m e n- dous growth as a result of diversification into fields as varied as electronics and health care. Firms and industries that are being denied access to the mainstre a m financial system have little choice but to The Jerome Levy Economics Institute of Bard College 7

8 An Alternative in Small Business Finance rely on unort h odox financing sources for investment and gro w t h. Interestingly, the rapid growth of factoring companies has not gone unnoticed by commercial banks. Indeed, banks are actively involved in the acquisition of and mergers among these factors via the banks holding companies, and they are now responsible for over 90 percent of the factoring being conducted in the United States. Assuming that capital development of the economy and fostering a climate that encourages entre p reneurial activity are among the objectives of an efficient and sound financial system, the heightened role of factors and the implications therein about the financial system merit serious attention in the discourse on policy. This re s e a rch on factoring companies in conjunction with the I n s t i t u t e s previous policy re s e a rch on community development banks, the re f o rm of the Community Reinvestment Act, and evidence of discrimination in access to and delivery of essential financial services reflects a seriousness of purpose in contributing to the public discussion of our nation s most pressing economic issues. Dimitri B. Papadimitriou Executive Director May Public Policy Brief

9 C o m m u n i t y - B a s e d Factoring Companies and Small Business L e n d i n g Robert M. Hutchens I. Introduction In the past two years bank profits have rebounded and bank net worth is now well in excess of re g u l a t o ry minimums. H o w e v e r, there is widespread concern that the improvement of financial conditions in the commercial banking sector has not induced additional lending, particularly lending to small business. Although the depressed state of demand in the United States has until re c e n t l y lowered the demand by small business for loans, trends in commercial banking make it unlikely that commercial banks will be willing and able to meet small business demand for loans even now that the economy is recovering. The authors would like thank Steve Fazzari, John Caskey, and Walker Todd for comments and Rich Eichhorn for research assistance. The Jerome Levy Economics Institute of Bard College 9

10 An Alternative in Small Business Finance T h e re is widespread recognition that our financial institutions are not providing an adequate level of services to certain identifiable segments of our communities, including low-income and minority households and businesses, especially in depressed neighborh o od s. Recent detailed studies have demonstrated that such neighborhoods a re systematically denied equal access to home mortgage loans (Munnell et al. 1992; Bradbury, Case, and Dunham 1989; Carr and Megbolugbe 1993). While similar data for commercial lending is not available, anecdotal evidence suggests that firms in these neighborh o ods are also underserved. Jerry Jordan, president of the Federal Reserve Bank of Cleveland, recently noted: Improving access to credit by minority and low-income communities represents a serious challenge to lenders, community residents, and government officials.... The deplorable condition of a lot of our neighborhoods in major cities across this c o u n t ry is clear evidence that something is terribly wro n g. The solution to this problem is economic development, an indispensable component of which is an effective banking system. (Jordan 1993 p. 1) G o v e rnor Lawrence Lindsey of the Federal Reserve Board echoed Jordan by saying: no single consumer issue is of greater concern than ensuring that the credit-granting process in the institutions that we regulate is free of unfair bias. (Lindsey 1993, p. 10) In two recent Public Policy Briefs published by The Jerome Levy Economics Institute, we proposed the creation of a system of community development banks (CDBs) to increase the provision of financial services to economically distressed communities (Minsky et al. 1993; Papadimitriou, Phillips, and Wray 1993). As part of that proposal, we advocated that the CDBs provide a range of services to small businesses in these communities to provide employment opportunities and to revitalize communities. We also called for strengthening the effect of the Community Reinvestment Act (CRA) by allowing investment by traditional financial institutions such as 10 Public Policy Brief

11 Community-Based Factoring Companies and Small Business Lending c o m m e rcial banks in community-based lenders such as CDBs to count toward fulfillment of CRA requirements. Lending to small business can be strengthened even further by encouraging the development of niche financial institutions that would supplement the activity of CDBs and commercial banks. This Public Policy Brief focuses on the role that can be played by commu - nity-based factor companies (CBFs). Factors supply credit to firms by p u rchasing their accounts receivable; in addition, they provide a wide range of other financial services. It is our belief that factors can play an important role in increasing the supply of credit and other financial services to small businesses if they are made a part of a c o h e rent strategy of community reinvestment. In part i c u l a r, if the CRA is strengthened and if investment by commercial banks in community-based factors is counted toward CRA compliance, then the a l ready significant role (at the small firm and community level) played by community-based factors in providing financial services to small business will be enhanced. In addition, the development of a nationwide system of CDBs should include a role for communitybased factors. In some cases, community-based factors could be members of the CDB system; in other cases, some CDBs might include factoring as one of the services that is provided to the community. The legislation offered by the administration to provide funding and technical assistance to community development financial institutions (CDFIs) has been approved by both the House and the Senate. This proposal will provide $382 million over four years to CDBs, community development credit unions, community development loan funds, microenterprise funds, and community development corporations. In addition, President Clinton has called for reform of the CRA. After a series of public hearings, the agencies in charge of regulating and supervising banks have proposed new CRA regulations. The most important of the proposed changes are the establishment of quantifiable service tests; the requirement to disclose more information on lending to small businesses, small farms, and consumers; and the encouragement of investment in CDFIs. We will argue that, in some cases, community-based factors should be eligible for funding and assistance under the pre s i d e n t s plan and that investment by The Jerome Levy Economics Institute of Bard College 11

12 An Alternative in Small Business Finance banks in these factors should count toward fulfillment of the new CRA regulations. II. Bank Concentration and Small Business Lending Recent evidence re p o rted by the Federal Reserve Bank of Dallas indicates that small business loans make up 15 percent of total loans at insured commercial banks and 44 percent of all business loans (Klemme 1993). However, the distribution of small business loans across commercial banks is skewed, with small banks the most active lenders to small business. The average asset size of active lenders to small business is only $100 million; in contrast, the average asset size of the least active lenders to small business is $1.2 billion. F u rt h e rm o re, small banks tend to make smaller loans. The typical bank with assets less than $100 million makes loans of less than $100,000, while the typical bank with assets in excess of $1 billion focuses on loans of at least $1 million. Small banks in the United States account for a meager portion of total lending. In 1987 less than 200 banks, representing the top 0.9 p e rcent of U.S. commercial banks, held 59.3 percent of all bank assets (Boyd and Graham 1992). The top 10 banks in 1990 held 22 p e rcent of all banking assets, and the top 25 held 38 percent. If a small bank is defined as one with $50 million in assets in 1984 and $66.3 million in 1992 (to account for inflation), then there were 9,217 small banks in 1984, accounting for 64 percent of all banks, but they held only 8.6 percent of all bank assets; in 1992 there were 6,692 small banks, 59 percent of the total, holding only 6.3 percent of total assets (Wheelock 1993). Between 1986 and 1993 nearly 4,250 banks were closed; of these, 1,021 were closed because of insolvency, 2,043 were converted into branches of bank holding companies, and 1,175 were purchased by other banks (DeYoung and Whalen 1994). During the same period almost 1,100 new bank charters were issued, which compensated for those lost to insolvency. The net change in the number of banks over the period represented a large loss due to mergers. Even more impor- 12 Public Policy Brief

13 Community-Based Factoring Companies and Small Business Lending tant than the loss in the total number of banks is the loss of independent (and primarily small) banks. More than 6,500 independent banks were lost between 1988 and 1993, many of which were acquired by bank holding companies. The asset share of independent banks fell from 22 percent in 1980 to 6 percent by 1993 (Nolle 1994). This is significant because small, local, independent banks can be an important source of credit to local business. Table 1 provides the distribution, by size, of insured commerc i a l banks in 1988 and The dramatic downward trend in banks in the smallest size category (less than $25 million) is evident from the nearly 50 percent drop in their number since At the same time the number of banks in the largest size category, over $5 billion, has grown by nearly 25 percent. Table 1 Number of Banks by Asset Size, 1988 and 1993 Number of Banks Asset Size December 1988 September 1993 Less than $25 million 4,040 2,314 $ million 6,135 5,544 $ million 1,889 2,122 $300 million $1 billion $1 5 billion Over $5 billion Total 12,982 10,977 Source: Federal Financial Institutions Examination Council, Uniform Bank Performance Report, September The Jerome Levy Economics Institute of Bard College 13

14 An Alternative in Small Business Finance The data on numbers of small banks can be somewhat misleading for two reasons. First, loss of small banks is offset to some extent by rising numbers of bank branches; the total number of bank offices (banks plus branches) grew by over 20 percent during the period from 1980 to 1991 (Nolle 1994). Second, many of the losses are attributable to mergers so that loss of a bank does not necessarily mean loss of the bank o f f i c e. However, it is our belief that the acquisition of small, independent banks by larger bank holding companies can, over time, lead to changes in operating procedures that can make it more difficult for small, local businesses to obtain loans (or, at least, to obtain loans on unchanging terms). Indeed, acquisition often occurs on the justification that the acquiring bank will rationalize operations and cut costs. Since it is often claimed that a small loan costs as much to administer as a large loan, attempts to cut operating costs can lead to a credit crunch for small firms. The effect on lending by small banks can be seen in Table 2. Not surprisingly, the total volume of loans by banks with less than $25 million in assets fell 37 percent between 1988 and At the same time the volume of loans by banks with over $5 billion in assets grew by 18 percent. Admittedly, the data presented do not definitively prove that the number of small loans has declined (we have not been able to obtain data on the size of loans made across bank categories). H o w e v e r, because small banks tend to make small loans, and big banks tend to make big loans, the data do support the presumption that small business loans have decreased in number. To be sure, when a small bank merges into a larger one, the established small firm small bank relationships are not necessarily destroyed, but the t e rms, including higher minimum balance re q u i rements and increased fees, most likely will change, becoming more costly for the borrower. 14 Public Policy Brief

15 Community-Based Factoring Companies and Small Business Lending Table 2 Total Bank Loans by Size of Bank, 1988 and 1993, and Percentage Change (dollars in billions) December 1988 September 1993 % of % of % Asset Size Loans T o t a l L o a n s T o t al Change Less than $25 million $ % $ % 37 $ million $ million $300 million $1 billion $1 5 billion Over $5 billion , Total $1, % $2, % 8% Source: Federal Financial Institutions Examination Council, Uniform Bank Performance Report, September Thus, the rising concentration in the commercial banking sector would suggest that small businesses are finding it increasingly difficult to maintain a relationship with a small bank that would be interested in making loans that suit their needs. Hard data on this credit crunch are difficult to obtain. There are no convenient data that categorize business firms according to access to capital markets, although the Federal Reserve Board s flow of funds data provide some evidence on small firm finance. (The limited data available indicate that while bank lending to small business has increased since the 1980s, this g rowth is largely due to a rise of commercial mortgage lending by banks (French 1994, p. 20).) The financial and popular presses, however, provide substantial anecdotal evidence. For many small businesses, obtaining traditional credit based on their balance sheets or anticipated cash flow has been more difficult. Factoring has become a convenient method to satisfy their working capital re q u i re m e n t s (Slater 1993, p. 38). It is easy to find other, similar statements. The Jerome Levy Economics Institute of Bard College 15

16 An Alternative in Small Business Finance Somewhat surprisingly, there appears to be no evidence that specialization in small business loans is less profitable; it is other considerations that are driving the trend to consolidation in commercial banking, which increases bank size beyond the scale that makes small loans attractive. Small firms rely to a much greater extent on commercial banks than do large firms, which have at their disposal many a l t e rnative forms of financing that are generally not available to small firms, including commercial paper. In October 1993 total commercial paper outstanding was $550 billion, while total commercial and industrial lending of all commercial banks was $586 billion (Federal Reserve Bulletin, 1994). The commercial bank share of U.S. financial assets held by all financial service firms was 51.2 percent in 1950, but only 26.6 percent in the third quarter of Similarly, Simonson (1994) reports that the ratio of finance company business credit to bank commercial and industrial loans rose from 20 percent in 1982 to 55 percent in This declining share of the financial services market held by commercial banks affects smaller business to a greater extent because it has fewer noncommercial bank options. T h e re are other causes of the reduction of the supply of credit to small business in the near term. Small firms rely to a greater extent than do large firms on collateral and asset-based lending. Small firm b o rrowing is frequently based on real estate values; the short - t e rm financing of inventories is another important collateralized loan for small firms, especially single family proprietorships. Dere g u l a t i o n, fear of litigation (product safety, environmental problems), concern over interest rate fluctuations, and unstable exchange rates have all e roded banker faith in long-established rules of thumb re g a rd i n g debt to equity ratios and cash flow to debt coverage ratios (Schlegel 1990). This, in turn, has caused banks to raise the stand a rds and costs of asset-based lending in which collateral must be pledged. Further, problems experienced during the 1980s have caused banks to be cautious and conservative when lending against assets. Of even greater concern is that while the credit crunch affects all firms, it has a greater effect on growing firms. Traditional, asset-based lending works against small but expanding firms that have larg e o rders to fill, but lack the financial means to expand prod u c t i o n. 16 Public Policy Brief

17 Community-Based Factoring Companies and Small Business Lending These firms typically find that potential revenues are growing faster than actual productive capacity. A tightening of conditions on collateral-based lending exacerbates this situation and the growth of these firms is constrained (Schlegel 1990). The credit crunch small firms are facing may be hindering economic recovery. The conventional wisdom is that small business will be the driving force that leads the nation along the path of economic g rowth, because nearly half of the nation s output is produced by small firms (Samolyk and Humes 1993) and because many economists believe that employment growth will occur first among small firms (Birch and Medoff 1993). There is some contro v e r s y, however, about whether small business is normally the driving force (Davis, Haltiwanger, and Schoh, forthcoming). While we cannot rely solely on small business to lead the economy out of stagnation, we do recognize that it can play an important national role and, in many cases, a decisive regional and local role. If, as the anecdotal evidence appears to indicate, the credit crunch is preventing small f i rms from undertaking potentially profitable projects, then eff o rt s must be made to increase the supply of credit to small business. However, we do not want to overemphasize the importance of small business lending; depressed neighborh o ods will re q u i re a variety of programs to restore vitality, including programs to increase mortgage and home rehabilitation lending, to provide more training and more jobs, to increase the supply of payment and savings facilities, and to promote entrepreneurship. III. The Role of Factoring Companies in Alleviating the Credit Crunch A factor raises funds by issuing commercial paper, notes, and debentures; it purchases accounts receivable a client, advancing about 80 percent of the value of the receivables; and it takes over billing and collection of the client s accounts. Once the client s customers have paid their bills, the factor pays the remaining value of the invoices to the client, after deducting a discount fee that ranges from 1 percent to 5 percent and interest charges on the advance. In addition, a factor may offer many financial services to the client. The Jerome Levy Economics Institute of Bard College 17

18 An Alternative in Small Business Finance Factor companies have traditionally served small to medium size firms engaged primiarily in textiles and apparel. Until the 1960s factors were usually independent and closely linked to the clients they serviced. In recent decades a trend toward consolidation has led to a two-tier factor sector composed of a few dominant, typically bankowned, large factors and a declining number of small, independent factors. At the same time factors have moved into new areas (such as health care, footwear, furniture, housewares, electronics, and foreign trade) and into new financing arrangements. In general, the smaller, independent factors have been more creative in developing new products, although their client base has been eroded by a decline in their traditional clients, the textile and apparel industries. This is particularly true for those small factors that specialized in providing finance for small retail stores. In the aggregate, the majority, in terms of numbers of customers of clients of factors, are retailers. As retailers consolidate, independent factors find their business shrinking. Thus, even while the volume of factor business grows quickly, the number of factors and the number of customers serviced by factors is likely to decline (Stuchin 1991). This is countered to some extent by the expansion of factoring beyond its traditional apparel industry base. S m a l l e r, independent factors, have found a niche market in which they can compete by providing to smaller, growth-oriented firms outside textiles and apparel specialized services that these firms cannot obtain from commercial banks and other competitors (Remolona and Wulfekuhler 1992; Doherty 1993). These factors are willing to take equity interests in their clients, and they will make secured and unsecured loans in excess of collateral offered. They are able to offer management advice and costly bookkeeping, credit, and collection services, thus taking over tasks that small businesses are fre q u e n t l y happy to unload so they may focus on what they do best. In short, factors are able to fill a gap and to alleviate the credit crunch in some cases. Factoring has advantages and disadvantages compared to commercial banking. Factors are not subject to the supervision and re g u l a t i o n imposed on commercial banks unless they are part of a bank holding c o m p a n y. For example, factors can avoid writing off loans and absorbing losses that banks would be re q u i red to recognize. While 18 Public Policy Brief

19 Community-Based Factoring Companies and Small Business Lending this is a potential source of risk and, in the bankruptcy of United Factors, a large factoring concern, unrecognized losses played a major role (Rutberg 1989) it also makes it possible for a factor to work closely with a client to work out of problems. Given the peopleintensive nature of small-scale factoring, the credit department of a factor is in a good position to monitor the financial condition of a client and to judge whether work-outs would be cheaper than calling in loans and forcing bankruptcies. Factors enhance the balance sheets of their clients in a way that cannot be duplicated by commercial banks. When a client sells its accounts receivables to a factor, its debt-to-equity and debt-to-asset ratios are improved, increasing its creditworthiness. Thus, the use of a factor can make it easier for the small business to obtain bank finance. Furt h e rm o re, the factor s balance sheet is more favorably affected when it purchases accounts receivable than a bank s balance sheet is affected when it accepts accounts receivable as collateral against a loan. (We will return to these points later.) Factors are also in a unique position to engage in pipeline finance, that is, to finance a series of borrowers as a product moves through the entire production and marketing process, beginning with raw materials and ending with retail sales. Finally, factors apparently did not engage in the fad lending LDC lending, commercial real estate, energy loans, and residential housing that commercial banks succumbed to during the 1980s (Andersen Consulting 1990b). Even bank-owned factors did not experiment with the types of loans that proved later to have high default rates. The only important exception was in the area of LBOs, where factors played a role in providing some of the finance. IV. Overview of the Factoring Business A. Historical Background Factoring is an old business, indeed. Factors were common by the time of Hammurabi, 4,000 years ago, making advances to manufac- The Jerome Levy Economics Institute of Bard College 19

20 An Alternative in Small Business Finance t u rers and merchants against goods. Early factors may have sold clients goods in addition to providing credit and collection services. Factoring was the dominant form of finance used in the American colonies before the Revolution. In colonial America New York factors acted as sales agents for British and European textile mills, selling the goods on a commission basis, perform[ing] the credit and collection function for their clients, guaranteeing the credits extended to their customers in this country, and advanc[ing] funds to the mills against these receivables and also against the goods received on consignment (Phelps 1956, p. 65). Eventually, factors stopped acting as sales agents and specialized in credit and collection services. As the U.S. textile industry developed, it followed the British and European practice of relying on factors for these services, and until this century U.S. factors focused almost exclusively on firms in the textile indust ry (including manufacturers, wholesalers, and retailers). It was not until the 1930s, partially due to the effects of the Great Depression, that factors expanded their business beyond textiles to wholesalers and retailers of other dry goods. By the 1950s factoring had spread to bedding, chemicals, cosmetics, dry goods, electrical appliances and supplies, fertilizer, furniture, garden hoses, gloves, hardware, hats, h o s i e ry, household furnishings, housewares, infants and childre n s wear, knit specialties, leather goods, linens, men s, women s, and children s apparel, metallic yarns, nylon fishing lines, paint, paper, piece g o ods, plastics, portable organs, radios, rubber goods, scre e n i n g, shoes, sporting goods, thread, toys, and underwear (Phelps 1956, pp ). Until quite recently more than half of the worldwide volume of factoring business was in the United States. During the 1980s, however, factoring experienced much faster growth abroad, and the United States no longer dominates the business. By the mid-1980s the U.S. share fell to less than half; by 1990 it was not much more than onesixth. During the last half of the 1980s factoring grew at a rate of 22 percent per year worldwide, but at a national rate of only 8.4 percent per year. Relatively slower growth in the United States might be the result of greater penetration by U.S. factors into domestic markets rather than those in the rest of the world, but may also be attributed to loss of U.S. textile manufacturing, the traditional factor business. 20 Public Policy Brief